CeFi and DeFi will finally meet in 2021 — Let's hope they hit it off

Published at: Jan. 3, 2021

The decentralized finance industry undoubtedly has vast potential — the value locked in it has exploded, surpassing $14 billion this month. Though there is speculation over whether decentralized finance is yet another bubble, I believe it is here to stay. How it stays, however, is another matter that depends on how DeFi handles ongoing hacks and other vulnerabilities, how centralized finance incorporates DeFi’s leading features and vice versa.

DeFi encompasses everything that the crypto space fundamentally stands for: democracy, power to the unbanked and underbanked, transnationalism, a truly global and shared economy, all of which many would consider financial utopia.

Yet no utopia has ever come into existence, and no extreme can sustainably progress toward its end goal unchecked. The enfants terribles in history usually meet an unhappy end unless they adapt to the realities of a less-than-utopian world. A golden mean between CeFi and DeFi must be met — both “factions” stand to benefit from it, as does the whole space.

What DeFi can take from CeFi

A lack of comprehensive and effective security auditing in DeFi has led to millions of dollars worth lost from hacks, which, seen through the lens of the world outside of crypto, where the CeFi–DeFi distinction is blurred, damages the reputation of the entire space. Within crypto, this has very much positioned DeFi as an enfant terrible, and for good reason — among code bugs, flash loan attacks, system vulnerability exploits and token design issues, there were more than 20 major DeFi hacks in 2020 for an amount topping $100 million.

Thankfully, over the past months, there has been increasing acknowledgement of the importance of better auditing — and auditing in general — among larger DeFi players and their communities. This is the first step in the right direction.

Auditing for DeFi is, of course, just as nascent an occupation as the industry itself, and while this means it is not yet up to scratch, it also leaves ample room for change and improvement — perhaps even for the development of an entirely new sub-industry, complete with standards and certifications, to address this single greatest weakness of DeFi. That security auditing model and best practice can be taken straight from CeFi and adapted to incorporate DeFi’s specifics.

The next step would be financial audits, which would address potential vulnerabilities from a market perspective. This would be a collaborative effort between traditional and digital finance, and it’s something that CeFi players are leading the conversation in.

With these issues covered, another DeFi challenge would be partially tackled: attracting institutional investment to guarantee long-term development. While DeFi’s anonymity, by default, inhibits large-scale capital inflows because institutional investors cannot enter into contractual obligations with an anonymous counterparty, better security would facilitate a relationship between CeFi and DeFi in this direction.

A similar issue emerges on the retail side, which is just as important in driving mass adoption. The complexity of most DeFi platforms makes them inaccessible due to the high degree of technical knowledge required to use them. This limits DeFi platforms’ chances of expanding their user base, in turn, making a breakthrough into the mainstream unlikely and stunting their growth potential. CeFi products, on the other hand, enjoy much greater adoption rates due to their user-friendliness and proximity to traditional digital banking tools. These formats can be transferred onto DeFi protocols to enhance user acquisition and retention.

Furthermore, there are currently ways in which DeFi is successfully adopting centralized components, and the fact that a substantial amount of wealth on DeFi platforms is held in stablecoins — the products of centralized organizations — is perhaps the best case in point. As such, stablecoins serve as a much-needed bridge between DeFi and CeFi.

What DeFi can give CeFi

There is much to admire about what DeFi has brought to the table this year, not least that it has presented opportunities for the unbanked to access banking services, offering the democratization that our entire space aims for.

Though blamed for most hacks, flash loans are DeFi’s absolute hallmark in that they are a prime example of how finance can be effectively democratized. In enabling anyone to operate like a whale and take advantage of market situations that would otherwise be unavailable to them as a smaller investor, they eliminate the phenomenon of the rich getting richer, while the less-wealthy stagnate due to a lack of financial tools or liquidity at opportune moments. With CeFi’s greater security and user-friendliness, these opportunities can be amplified and presented to an entire market of potential unbanked and underbanked users.

There are also positives to take from some of the DeFi projects that collapsed this year. The “right to fail” is an important part of the learning process for an industry as young as ours that makes us more resistant, even anti-fragile. This is in sharp contrast with traditional finance, where mistakes, big and small, are swept up thanks to governments and central banks’ interventionist policies. I believe this to be the fundamental flaw of the current financial system. Our space demonstrates how the true forces of the market are played out, and DeFi, with its many hacks over the past year, has illustrated this perfectly. I admire the likes of Harvest, Value DeFi and Yam for flagging their mistakes. It goes to show that the whole crypto space, in general, is maturing and growing stronger.

As DeFi currently stands, it is unlikely to spill over the borders of its own niche despite the steep climb we witnessed in 2020. It will plateau over the coming year as some projects fail and disappear, while others adapt and put into motion mechanisms to self-regulate, giving way to a more sustainable modus operandi that is better aligned with CeFi’s.

A combination of DeFi’s ideals — a system without vertical authorities where proceedings are democratically and transparently agreed upon by the community — and the security measures and ease of use brought by CeFi will facilitate mass crypto adoption to ultimately yield a fairer financial environment.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Antoni Trenchev is the co-founder and managing partner of Nexo, a provider of instant crypto credit lines. He studied finance law at King’s College London and Humboldt University of Berlin. As a member of Bulgaria’s parliament, Trenchev advocated for progressive legislation to enable blockchain solutions for a variety of e-government services, most notably e-voting and the storage of databases on a distributed ledger.